Gostudymock3

Oscillators & Indicators - Tools for Technical Analysis



This post is part of our mini-series on technical analysis which covers exactly how this material might show up on the Level 1 CFA exam.

In our last two posts we covered the 4 major charts used in technical analysis and then dove into how to interpret the major types of chart patterns.

This post picks up where those left off and talks about other key technical indicators used in technical analysis. 

The Major Types of Technical Indicators

technical indicator looks to predict the future price levels, or simply the general price direction, by examining a security’s supply and demand (as represented by past trading activity).

There are four main types of technical indicators:

  • Price-based indicators
  • Momentum oscillators
  • Sentiment indicators
  • Flow-of-funds indicators

Price-based Indicators

There are two major price-based indicators: moving averages and bollinger bands.

Moving Averages

Frequently used to smooth out price changes, moving averages are simply the graphical representation of the average of n closing prices (although there are different variations of moving averages). Common time periods used are 20 day (# of trading days in a month) and 50 day patterns. The longer the time period in question the more short-term trends are ignored. Relying more on long term trends can be helpful in cutting out market noise but increase the odds of being ate to the development of a key trend.

Thus analysts will often combine different moving averages in a complementary fashion. For example, if we are using a 50 day and 100 day moving average, and the 50 day line crosses the 100 day moving average that can indicate either a bullish or bearish cross depending on the direction it crosses over. Here is an example of a bullish cross: Bullish Cross - CFA L1 Technical Analysis

One final point to remember here: In an uptrend the actual stock prices are higher than the moving average (and lower for a downtrend). So if we plot a set of moving averages in a line, what we’re really doing is drawing a support or resistance line for that given trend.

Bollinger Bands

Bollinger bands are built based on the standard deviation of closing prices over n periods (we usually use two standard deviations). Bollinger bands are useful to examine whether prices are extreme relative to recent levels. If the prices are two standard deviations below the lower Bollinger band the market could be viewed as oversold. If prices are above the upper Bollinger band the market could be overbought which opens up the possibility of a contrarian trading strategy. Note the wider the bands the more volatile the stock, the narrower the less volatile.[1]

This is best understood graphically:

Bollinger Bands - CFA L1 Technical Analysis

Momentum Oscillators

RSI and MACD are the most likely to be tested on the CFA L1 exam in our opinion. While the Level one curriculum shows various calculations the LOS indicates you will not need to calculate anything.

Oscillators are another group of tools used to identify overbought or oversold market conditions. They are also based on prices but are scaled in such a way that they “oscillate” around a certain value or between high and low values. For oscillators extreme high values indicate overbought markets while extreme low values indicate oversold markets.

Oscillators are perhaps most useful in identifying convergence and divergence. Convergence happens when the oscillator confirms the same pattern as the price movement. Divergence occurs when the oscillator contradicts the price pattern. 

For the exam you need to know four different types of oscillators:

  • Rate of Change (ROC) Oscillator
  • Relative Strength Index (RSI)
  • Moving Average Convergence/Divergence (MACD)
  • Stochastic Oscillator

Rate of Change (ROC) Oscillator

ROC shows the percentage difference between the current price and the price n periods ago. In other words it measures the percentage change in price over a given period. The higher the percentage change in price the higher the ROC. Note the ROC oscillates around zero. When the price goes up, ROC goes down and vice versa.  Traders will often buy if the oscillator goes from negative to positive in an uptrend, or sell when it goes from positive to negative in a downtrend. If it crosses zero in the opposite direction of the trend it is usually ignored.

Relative Strength Index (RSI)

RSI measures the relative strength of a security against itself.  It is scaled to oscillate between 0 and 100 with high values (> 70) showing an overbought market and low values (< 30) showing an oversold market.

  • RSI > 70, Sell Signal
  • RSI < 30, Buy Signal

Moving Average Convergence/Divergence (MACD)

MACD (pronounced Mac-Dee) is an exponential moving average that shows the difference between short and long term moving averages.[1] The MACD signal line itself then oscillates around zero (but is not bounded).

MACD can signal convergence or divergence as well as overbought and oversold conditions. Points where the MACD line crosses the ‘signal’ line can be used as trading signals. As you might have guessed, the shorter-term average crossing above the longer term line shows upside momentum increasing and is thus a bullish signal (and the opposite is true for crossing below):

 MACD on the CFA L1 Exam

Stochastic Oscillators

The stochastic oscillator measures the relationship between the closing, high, and low prices and is also used to identify overbought and oversold markets. It is usually calculated using a 14 day period and always ranges between 0-100%.  In an uptrend the closing price tends to be near the high price of the period and a downtrend is marked by the low and closing prices being close together. Generally a buy signal occurs if the oscillator crosses above the 20% level and a sell signal is triggered if it crosses below the 80% level.

Sentiment Indicators (Non-Price Signals)

Sentiment indicators can include polls/surveys of market participants or, more commonly, calculated statistical indices. We’ll rip through the ones in the curriculum, again much of this is in the weeds and unlikely to show up with any significance on the exam.

  • Put/Call Ratio:

This is a contrarian indicator. The higher (lower) the ratio the more bearish (bullish) the signal. However if the ratio is skewed to one extreme or the other things are different. For example an extremely high ratio demonstrates excessively negative sentiment and the price is likely to rise.

  • Volatility Index (VIX) - Calculated by the Chicago Board Options Exchange, the VIX measures options volatility. A high or rising VIX is a bearish sign, however, market participants use the VIX as a contrarian schedule.
  • Margin Debt - Increases in margin debt outstanding indicate increasing bullishness amongst investors.
  • Short interest ratio – Short interest is the number of shares investors have borrowed and sold short. The short interest ratio is that number divided by the average trading volume. A high short interest ratio indicates traders expect prices to decline, however, it also means at some point there will be greater buying demand as the traders have to cover their shorts (if this happens in the short term it can result in a short squeeze)
  • Flow of Funds Indicators – Indicate the relative supply and demand in the market. One particularly useful ratio is the arms index or short-term trading index.

The TRIN measures funds flowing into advancing and decreasing stocks. A ratio close to one suggests an even distribution, a ratio greater than one means more money is flowing into declining stocks. Spikes upwards have historically corresponded to large daily losses.

Other flow of funds indicators include the aforementioned margin debt, the mutual fund cash position (ratio of cash to total assets). Traders use this as a contrarian indicator. When cash balances increase there is future buying demand and traders expect the markets to rise.

  • New Equity Issuances – IPOs etc. A lagging indicator thought to coincide with market peaks since an IPO becomes more attractive to the business owners as prices rise.

Our final post in this mini-series talks about the Elliott Wave Theory.

Footnotes

[2] Using an exponential average means that more weight is put on short-term observations.

[1] http://www.traderplanet.com/tutorials/view/162847-volatility-indicator-bollinger-bands/